Raising interest rates would be a mistake

We are approaching the fourth anniversary of official interest rates reaching a record low of just 0.5% in March 2009 and concerns have been growing about the damage caused by such a prolonged period of low interest rates. However, raising interest rates would cause even greater damage.

Groups such as 'Save Our Savers' have long complained about the low level of official interest rates on savings. And the Institute of Economics Affairs Shadow MPC actually voted for an immediate interest rate rise at its last meeting. So is there really a case to be made for raising rates?

Reasons not to raise rates

Some of the arguments for a hike can be dismissed fairly easily. For example, some have argued that rates should be raised in order to pull down inflation and boost real pay.

But the factors that have pushed up inflation (such as a fall in the pound and in energy prices) imply an unavoidable adjustment in real pay.

As Mervyn King has repeatedly told us, the only way to have lower inflation would be to generate a sharper economic downturn in order to reduce domestically-generated price pressures. This would raise unemployment and reduce nominal pay growth - leaving consumers no better off.

Meanwhile, we find it hard to see why interest rates should be increased just to boost savings incomes. After all, the very way looser monetary policy is designed to work is by discouraging saving and encouraging borrowing and spending (although lower savings income could encourage some households to save more to reach any target level of savings they have).

If the government is worried about the distributional impact of low interest rates, it could deal with that through fiscal policy.

Meanwhile, we give short shrift to the idea that raising rates would be a signal that things are getting back to normal and would inspire confidence.

We imagine it would make most people think that we really are in dire straits. And it would be pointless to raise rates to rebuild the MPC's policy ammunition for the future, if the rise just triggered the economic downturn that would require them to be cut again.

Reasons to raise rates

A couple of arguments perhaps deserve closer attention.

One - the IEA argument - is that the long period of low interest rates is resulting in a misallocation of capital, preventing 'zombie' firms from going bust and their resources being reallocated to more productive sectors.

For example, bank loans to companies that are just treading water are tying up banks' balance sheets and preventing new lending to more viable companies.

This echoes the so-called 'Austrian school', which argues that recessions are necessary, and indeed healthy, as a means of aiding 'creative destruction'.

Accordingly, the IEA argued that the recent pick-up in confidence was an opportunity to raise rates and resolve some of these problems without too damage to the economy in the short-run - especially as problems in the banking system meant that low interest rates are having a less beneficial effect than in the past.

Second, the fact that inflation is projected by the MPC to overshoot its target for yet another two years suggests there might also be an argument for raising rates to stave off the risk of a rise in inflation expectations – which would then necessitate a bigger tightening of policy further ahead.

This was one of the main reasons why three MPC members voted to raise interest rates in early 2011.

But we don't think these factors justify a rate rise. Letting zombie firms fail might free up resources – but do little to create extra demand to redeploy those resources.

The result would be a rise in unemployment, drop in confidence and scrapping of capital – more destructive destruction than creative destruction. Although the transmission of monetary policy is impaired, that does not mean that a rate rise would be harmless.

There may be some asymmetry here. For example, while banks did not pass on all of the cuts in official interest rates, they would surely be very quick to pass on all of a rise.

As for the risk to inflation expectations, we have never been convinced that this was a serious problem and so far, they have risen only modestly. We have pointed out before that inflation expectations have become a lagging, rather than leading indicator, of inflation.

And even if they did rise, we doubt that they would spark some sort of wage-price spiral like that seen in the past, when unemployment is still high and restricting workers' bargaining power.

Thankfully, the MPC seems to share our view on all of this and has indicated that it intends to maintain the current accommodative stance of monetary policy. Indeed, we think that interest rates will remain at their ultra low levels for at least a couple of years more and possibly much longer.

Vicky Redwood is chief UK economist at Capital Economics

Inflation

An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).

Vote now in the Moneywise Customer Service Awards survey and help us identify the most trusted financial service providers in the UK. Enter the prize draw to stand a chance of winning £1,000 cash or £100 in shopping vouchers.

Vote now on our poll

Ahead of the General Election in May, which political party do you believe will be best for your household finances?:

More information

Our other sites

News, articles and guides on all things money related, from pensions and investments to savings and mortgages. Moneywise offers independent news and views, video and blogs as well as uniquely independent and interactive comparison services.